Monday, November 24, 2008

Inflation Swaps are currently pricing in "expectations" of deflation of 1.5% over 2 years and inflation just over zero over five years. Ten and twenty year numbers are both well below 2% each.

U.S. TIPS price in a much greater chance of deflation as hedge fund unwinds and a flight to liquidity have put extreme pressure on the TIPS market (per Bloomberg).

The breakeven rate, or the difference in yield between two- year inflation-protected and nominal debt, suggest traders are betting the economy may face deflation over the next two years. The two-year breakeven rate was minus 3.96 percentage points.

The basic idea is that, in the present environment, nominal Treasuries have a negative beta. If we go into Depression, the expectation is that this will be accompanied by substantial deflation, so that Treasuries will do well in real terms. In contrast, the typical pattern is different--perhaps bad times are usually accompanied by high inflation or at least average inflation. Therefore, especially at the shorter end, the relation between indexed and conventional Treasuries has shifted--the real rate on indexed bonds now has to be well above the expected real rate on nominal bonds.